Fed Paying Interest on Reserves: A Primer - Real Time Economics - WSJ: The Federal Reserve used all the weaponry in its arsenal during the financial crisis, and created some new ones. The Treasury’s decision to pull back one innovation — in which the Treasury sold bonds and put the money on deposit at the Fed — has put the spotlight on another one. Because of an act of Congress, the Fed now has the power to pay interest on the reserves that banks leave on deposit at the Fed. That’ll change the way the Fed manages the economy in the future — but only in ways that credit market geeks can understand.
For years, the Fed’s primary tool has been the federal funds interest rate, the rate that banks charge each other for overnight loans. Banks with more reserves than they need to comply with legal minimums lend to others who need reserves. The Fed’s policy committee — the Federal Open Market Committee — sets a target for that rate, but doesn’t control it. It influences it by affecting the supply and demand for reserves in the open market. In the past, when it wanted rates higher, it would announce a new target with much fanfare and then the next day reduce the supply of reserves — usually by selling securities from its portfolio which drained cash from the banking system. Rates usually responded to the announcement in anticipation of the actual Fed market maneuvers. When the Fed wanted rates lower, it did the opposite. Changes in the fed funds rate ricochet through the economy. Higher rates tend to discourage consumer and business borrowing and slow economic activity.
Today, the Fed’s target for the fed funds rates is near zero and the banking system is awash with reserves. Many of those reserves aren’t being lent to other banks which can then use them to lend them to customers. Instead, they’re on deposit with the Fed. Until recently, the Fed didn’t pay interest on these reserves. Now it does.
That changes things.
Someday, the Fed will declare the emergency over and decide to tighten credit. There’s concern that because there are so many reserves sloshing around the banking system and all sorts of ordinary relationships have been distorted by the crisis and the Fed’s response that it won’t be able to get the fed funds rate up simply by announcing a new target and then reinforcing that with open-market operations. After all, as the Federal Reserve Bank of New York acknowledged earlier in the crisis, from “time to time” its trading desk has been “unable to prevent the federal funds rate from falling to very low levels.”
So now when the Fed decides it wants to raise the fed funds rate, it now has two options: It can affect the SUPPLY of reserves as it used to by buying and selling Treasury securities on the open market. Or it can influence the DEMAND for reserves. If it raises the interest rate it pays on reserves, it will encourage banks to put more reserves on deposit at the Fed and lend less of their reserves to other banks in the interbank market. That should push the fed funds rate up. This, the Fed says, will mean less credit and higher interest rates throughout the banking system. “Paying interest on excess balances just makes it easier for the [New York Fed trading] Desk to implement the target federal funds rate chosen by the FOMC,” the New York Fed says.
“Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve,” Fed Chairman Ben Bernanke told Congress earlier this year. “Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits.”
This new tool, the Fed says to anyone who will listen, should reassure anyone that’s worrying that the Fed has the technical capacity to raise interest rates when the time comes.